The IRS recently published some tips on hardship distributions for plan sponsors on its website. The IRS also describes some of the most common compliance errors that have been discovered during plan audits and explains how to avoid them.

Following is an overview of the IRS tips and some additional insights for plan sponsors.

Plan sponsor missteps

IRS agents have found that some plans make hardship distributions to participants even though their plan documents do not permit hardship distributions. Fortunately, this type of error may be corrected under the IRS’s Self Correction Program by adopting a retroactive plan amendment to allow hardship distributions.

Agents also found that some plans make hardship distributions available for reasons not permitted under the plan. For example, if a plan only allows hardship distributions to pay tuition and related expenses, then it cannot permit hardship distributions for other purposes, such as unreimbursed medical expenses or the purchase of a principal residence. This is not a problem with a prototype plan, since all allowable safe harbor reasons are provided and employers are not given the option of choosing specific hardship reasons.

Avoiding errors

To avoid these types of errors, plan sponsors should carefully read the plan document to verify that the plan has hardship provisions in the first place and review what they are. Plan sponsors should conduct a thorough review of their plan’s terms by focusing on these questions:

• Does the plan document allow participants to take hardship distributions?

o      Note that hardship distributions are not a protected benefit and may be removed prospectively by a plan amendment.

• Is the plan’s definition of a hardship clearly defined?
• What are the procedures employees must follow to request a hardship distribution?
  • They should be clear and easy to follow.
  • They should explain the safe harbor reasons for receiving a hardship distribution.
  • They should explain the requirement that other assets must be taken first.
• Does the plan place any limits on the amount and type of funds that can be used in a hardship distribution from an employee’s account?

o      The amount of a hardship distribution is limited to the heavy and immediate financial need plus the taxes that will be due on the hardship distribution.

o      Elective deferrals may be withdrawn but not earnings on deferrals after 1988.

o      A plan may permit participants to take vested nonelective contributions and matching contributions as hardship distributions.

o      A plan may not permit participants to take qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), or safe harbor 401(k) contributions as hardship distributions.

o      A plan may permit rollovers and transfers to be withdrawn as hardship distributions.

Documentation tips

Participants must be able to provide documentation that proves there is a hardship. And plan administrators are required to verify that the documentation will establish that a participant has an immediate and heavy financial need. However, the IRS has never actually provided guidance on what it considers acceptable documentation. If a plan is audited, the IRS agent will look for documentation that the plan sponsor confirmed that the employee requesting the hardship had exhausted other permitted plan distributions, such as a plan loan, and that the hardship distribution didn’t exceed the amount necessary to satisfy the participant’s immediate and heavy financial need.

Applying electronically

The popularity of arranging for a hardship distribution electronically is growing. As part of the process, a participant may self-certify that he or she has met the plan’s hardship distribution criteria. However, the fact that the distribution application was processed electronically does not relieve a plan sponsor of the need to gather documentation as proof of the validity of the applicant’s immediate and heavy financial need. Once the participant has applied for a hardship distribution electronically, it is recommended that the plan sponsor gather copies of the supporting documentation. The IRS indicated that agents will look for documentation that supports the participant’s request and proves that the plan sponsor’s hardship distribution process is in compliance.

You can link to the IRS articles on hardship distributions at www.irs.gov/Retirement-Plans/Hardship-Distribution-Tips-For-You-and-Your-Plan-Participants and www.irs.gov/Retirement-Plans/Examination-Tips-for-Hardship-Distributions